J. Michael Scarborough and Royal Alliance Associates, Inc
SECURITIES ACT OF 1933
Release No. 8438 / July 8, 2004
SECURITIES EXCHANGE ACT OF 1934
Release No. 49982 / July 8, 2004
Admin. Proc. File No. 3-11538
In the Matter of J. Michael Scarborough and Royal Alliance Associates, Inc., Respondents. |
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ORDER INSTITUTING ADMINISTRATIVE AND CEASE-AND-DESIST PROCEEDINGS, MAKING FINDINGS, AND IMPOSING REMEDIAL SANCTIONS AND A CEASE-AND-DESIST ORDER PURSUANT TO SECTION 8A OF THE SECURITIES ACT OF 1933 AND SECTION 15(b) OF THE SECURITIES EXCHANGE ACT OF 1934 |
I.
The Securities and Exchange Commission ("Commission") deems it appropriate and in the public interest that public administrative and cease-and-desist proceedings be, and hereby are, instituted pursuant to Section 8A of the Securities Act of 1933 ("Securities Act") and Section 15(b) of the Securities Exchange Act of 1934 ("Exchange Act") against J. Michael Scarborough and Royal Alliance Associates, Inc. (collectively, "Respondents").
II.
In anticipation of the institution of these proceedings, Respondents have submitted Offers of Settlement (the "Offers") which the Commission has determined to accept. Solely for the purpose of these proceedings and any other proceedings brought by or on behalf of the Commission, or to which the Commission is a party, and without admitting or denying the findings herein, except as to the Commission's jurisdiction over them and the subject matter of these proceedings, Respondents consent to the entry of this Order Instituting Administrative and Cease-and-Desist Proceedings, Making Findings, and Imposing Remedial Sanctions and a Cease-and-Desist Order Pursuant to Section 8A of the Securities Act of 1933 and Section 15(b) of the Securities Exchange Act of 1934 ("Order"), as set forth below.
III.
On the basis of this Order and Respondents' Offers, the Commission finds that:
Respondents
1. Royal Alliance Associates, Inc. ("Royal Alliance") is a Delaware corporation with its main offices in New York, New York. Royal Alliance has been registered with the Commission as a broker-dealer and investment adviser since November 1984 and September 1997, respectively.
2. J. Michael Scarborough ("Scarborough"), age 50, has been the manager of Royal Alliance's branch office in Annapolis, Maryland ("branch office") since 1996. During the relevant time period, the branch office employed approximately fifteen registered representatives and engaged almost exclusively in the sale of mutual funds.
Introduction
3. This matter involves violations of the federal securities laws by Scarborough in connection with the offer and sale of Class B shares issued by mutual funds, as well as supervisory failures by Scarborough and Royal Alliance. From 1998 through early 2000, Scarborough, through the registered representatives under his supervision, sold brokerage customers Class B mutual fund shares in amounts that would have entitled them to "breakpoint" discounts had they purchased Class A shares of the same funds. Scarborough, along with the registered representatives, disclosed the characteristics of Class A shares and Class B shares to customers, including a description of the discounts to which the customers would have been entitled, but did not tell them that Class A shares generally produce higher returns than Class B shares of the same mutual fund when purchased in amounts of $100,000 or more. If all of the clients who purchased Class B shares in amounts of $100,000 or more had purchased Class A shares instead, Scarborough and Royal Alliance would have received $1.7 million less in commissions than they actually received.
4. Scarborough also failed reasonably to supervise registered representatives at the branch office who engaged in this conduct under his direction. Similarly, Royal Alliance failed reasonably to supervise Scarborough, its branch manager, as well as the registered representatives, with regard to these mutual fund sales practices. Although Royal Alliance had policies and procedures addressing the type of sales practices that Scarborough utilized, it failed to implement systems to adequately monitor compliance with these policies and procedures.
"Breakpoints" and Mutual Fund Shares
5. Many mutual funds, including those sold in connection with this matter, offer more than one class of shares. For each class of shares, a mutual fund's distributor uses a different method to collect sales charges from investors. Class A fund shares generally are subject to an initial sales charge ("front-end load") and a relatively low rule 12b-1 fee. The rule 12b-1 fee is an asset-based fee paid by the investor to the mutual fund's distributor specifically to compensate it for its distribution costs, including commissions paid to broker-dealers and their registered representatives selling fund shares. Class B shares are subject to a contingent deferred sales charge ("CDSC") if redeemed prior to the expiration of a holding period specified in the prospectus and a rule 12b-1 fee higher than that of Class A shares. Class B shares automatically convert to Class A shares after a specified number of years (in this case, seven years). The amount of the CDSC declines over the six-year holding period (5%, 4%, 3%, 3%, 2% and 1%).
6. Discounts are available for large purchases (usually $100,000 or more) of Class A shares, often increasing at higher investment levels, or "breakpoints." Investors may also qualify for breakpoint discounts pursuant to a "letter of intent," an agreement to make multiple purchases of Class A shares issued by the same fund or fund complex over a 13-month (or similar) period which, when aggregated, equal an amount that qualifies for a breakpoint discount. Breakpoints are also available through "rights of accumulation," under which an investor, or an eligible group of related investors (e.g., the customer, spouse and minor children), may aggregate the value of their existing holdings to determine the reduced sales charge applicable to subsequent purchases of Class A shares. Importantly, these breakpoint discounts are not available for purchases of Class B shares regardless of the size of the investment. Because Class B shares do not offer breakpoints, brokers can earn a larger commission on a large investment in Class B shares than they would on an investment in Class A shares of the same fund.
Scarborough's Disclosure Practices Concerning Class B Shares
7. The practice of the brokers under Scarborough's supervision at the Royal Alliance branch office was to recommend Class B shares to their customers. Scarborough was aware of the practice and encouraged it. By selling Class B shares, regardless of the availability of breakpoint discounts, Scarborough increased commissions for the firm.
8. Between 1998 and early 2000, of the 406 broker-dealer customers who qualified for a breakpoint at the $100,000 level or above, 399 customers, or 98%, purchased Class B shares even though all of these customers would have paid lower commissions and fees and enjoyed higher overall returns had they purchased Class A shares. As the branch manager of the office, Scarborough reviewed and approved these sales of Class B shares to customers. As a result of these sales of Class B shares, Scarborough and his brokers received $1.7 million more than they would have received had the customers purchased Class A shares instead.
9. In selling mutual funds, the registered representatives provided prospectuses to investors, as well as sales letters and other information. The prospectuses generally described the differences between Class A and Class B shares, including the availability of breakpoints and the fact that Class A shares charged lower fees. The prospectuses also stated that Class B shares were subject to a CDSC.
10. Royal Alliance also required that each investor who purchased a mutual fund execute a form letter styled "explanation of investment" that also disclosed the differences between Class A and Class B shares and disclosed the availability of breakpoints.
11. In addition to the disclosures set forth in paragraphs 9 and 10, the registered representatives made oral presentations and provided written materials to customers purchasing Class B shares. Scarborough was responsible for the materials provided to investors, and reviewed the content of letters and other disclosures.
12. For example, after speaking with customers and recommending the purchase of Class B shares, the registered representatives sent letters to customers stating, "As we discussed, I have recommended using 'B' shares, which have a deferred sales charge. This means that all of the assets will go to work for you immediately, giving you the full benefit of any growth of the investment. "
13. The registered representatives, at Scarborough's direction, also sent customers a document entitled "Investing Your IRA", which described the purported benefits of Class B shares. In relevant part, this document, after acknowledging the customer's decision to purchase Class B shares, stated that:
[The purchase of B shares] alleviates upfront commissions normally charged to you. Instead, our compensation comes to us directly from the mutual fund companies for the ongoing management of your assets. Such an arrangement works well for clients with a long-term investment horizon and a need to balance both growth and income.
14. In recommending that customers purchase Class B shares in amounts of $100,000 or more, neither Scarborough nor the registered representatives disclosed to customers the important fact that an equivalent investment in Class A shares could yield a higher return as a result of the availability of breakpoint discounts and reduced ongoing expenses.
15. At the time that Scarborough and the registered representatives failed to make proper disclosure about the benefits of Class A shares, they were aware of Royal Alliance policies that advised that Class A shares of mutual funds were generally a more suitable option for purchases in excess of $100,000.
16. Royal Alliance's 1999 "Sales Practices Manual", which was provided to Scarborough, stated, in pertinent part:
It should be noted that 'B shares' may not be appropriate for large fund purchases, since the client does not get the benefit of breakpoints. 'A shares' generally are a more suitable option for purchases in excess of $100,000, and should be used for single purchases above $250,000.
17. In addition, the 1998, 1999 and 2000 annual compliance outlines provided to the Annapolis branch office by Royal Alliance contained exhibits that gave a detailed explanation of why Class B shares were not appropriate for customers investing large sums, explaining that " 'A Shares' are generally a more suitable option for purchases in excess of $100,000 and probably should be used for all purchases above $250,000."
Scarborough's Failure to Supervise the Registered Representatives
18. As the Royal Alliance branch manager, Scarborough was responsible for the supervision and training of the registered representatives at the branch office. He was responsible for ensuring that they received proper training on and complied with policies and procedures concerning, among other things, sales practices concerning mutual funds.
19. As the branch manager, Scarborough failed to ensure that the registered representatives, whom he knew were recommending that their customers purchase Class B shares, made adequate disclosures concerning the relative cost benefits between Class A shares and Class B shares once customers qualified for breakpoints.
Royal Alliance's Failure to Supervise Scarborough and the Registered Representatives
20. Royal Alliance failed reasonably to supervise Scarborough and the branch registered representatives with a view to preventing their violations. Although Royal Alliance had a policy that stated that Class A mutual funds were generally a more suitable option for purchases in excess of $100,000, it failed to effectively monitor and enforce that policy in this case.
21. Although Royal Alliance conducted annual compliance examinations of the Annapolis branch office, these examinations failed to make adequate inquiries concerning the fact that Scarborough's registered representatives were selling a large number of customers Class B shares at amounts of greater than $100,000.
22. Further, Royal Alliance's surveillance system did not provide for the adequate enforcement of its policies. Instead, the firm relied largely on the branch manager to enforce these policies.
23. In August 2002, Royal Alliance adopted a new policy regarding the sale of mutual funds. Registered representatives are now not permitted to recommend the purchase of Class B shares to a customer in amounts aggregating more than $100,000 in a single mutual fund family within a 13-month period. It also enhanced surveillance capabilities to better ensure the policy is being followed.
Violations
24. As a result of the conduct described above, Scarborough willfully1 violated Sections 17(a)(2) and 17(a)(3) of the Securities Act which, among other things, prohibit material misstatements and omissions in any offer or sale of securities. Negligent conduct can violate those Sections.
Supervisory Failures
25. As a result of the conduct described above, Scarborough failed reasonably to supervise the registered representatives at the branch office, within the meaning of Section 15(b)(6) of the Exchange Act, with a view to preventing their violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act.
26. As a result of the conduct described above, Royal Alliance failed reasonably to supervise Scarborough and the registered representatives at the branch office, within the meaning of Section 15(b)(4) of the Exchange Act, with a view to preventing their violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act.
Royal Alliance's Remedial Efforts
27. In determining to accept the Offer, the Commission considered the revised policies and procedures described in paragraph 23 that Royal Alliance adopted and the cooperation of both respondents afforded to the Commission staff.
Undertakings
Scarborough shall provide to the Commission, within 30 days after the end of the nine-month suspension period described in Section IV below, an affidavit that he has complied fully with the sanctions described therein.
IV.
In view of the foregoing, the Commission deems it appropriate and in the public interest to impose the sanctions specified in Respondents' Offers.
Accordingly, it is hereby ORDERED:
A. Royal Alliance is hereby censured;
B. Pursuant to Section 8A of the Securities Act, that Scarborough cease and desist from committing or causing any violations and any future violations of Sections 17(a)(2) and 17(a)(3) of the Securities Act;
C. Pursuant to Section 15(b)(6) of the Exchange Act, that Scarborough be, and hereby is, suspended from association in a supervisory capacity with any broker or dealer for a period of nine months, effective on the second Monday following the entry of this Order;
D. Scarborough shall, within 30 days of the entry of this Order, pay disgorgement (representing the commissions referred to in paragraph 8 above) and prejudgment interest thereon in the total amount of $2,111,084. Such payment shall be made according to a distribution plan, suitable to the Commission staff, designed to reimburse those customers of Royal Alliance who incurred unnecessary expenses as a result of the conduct described above;
E. Scarborough shall, within 30 days of the entry of this Order, pay a civil money penalty in the amount of $50,000 to the United States Treasury. Such payment shall be: (A) made by United States postal money order, certified check, bank cashier's check or bank money order; (B) made payable to the Securities and Exchange Commission; (C) hand-delivered or mailed to the Office of Financial Management, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Alexandria, Stop 0-3, VA 22312; and (D) submitted under cover letter that identifies Scarborough as a Respondent in these proceedings, and the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Arthur S. Gabinet, District Administrator, Securities and Exchange Commission, 701 Market Street, Suite 2000, Philadelphia, PA 19106.
Such civil money penalty may be distributed pursuant to Section 308(a) of the Sarbanes-Oxley Act of 2002 ("Fair Fund distribution"). Regardless of whether any such Fair Fund distribution is made, amounts ordered to be paid as civil money penalties pursuant to this Order shall be treated as penalties paid to the government for all purposes, including tax purposes. To preserve the deterrent effect of the civil penalty, Respondent Scarborough agrees that he shall not, in any Related Investor Action, benefit from any offset or reduction of any investor's claim by the amount of any Fair Fund distribution to such investor in this proceeding that is proportionally attributable to the civil penalty paid by Respondent Scarborough ("Penalty Offset"). If the court in any Related Investor Action grants such an offset or reduction, Respondent Scarborough agrees that he shall, within 30 days after the entry of a final order granting the offset or reduction, notify the Commission's counsel in this action and pay the amount of the Penalty Offset to the United States Treasury or to a Fair Fund, as the Commission directs. Such a payment shall not be deemed an additional civil penalty and shall not be deemed to change the amount of the civil penalty imposed against Respondent in this proceeding. For purposes of this paragraph, a "Related Investor Action" means a private damages action brought against Respondent Scarborough by or on behalf of one or more investors based on substantially the same facts as alleged in the Order in this proceeding;
F. Royal Alliance shall, within 30 days of the entry of this Order, pay $1 in disgorgement and a civil money penalty in the amount of $150,000 to the United States Treasury. Such payment shall be: (A) made by United States postal money order, certified check, bank cashier's check or bank money order; (B) made payable to the Securities and Exchange Commission; (C) hand-delivered or mailed to the Office of Financial Management, Securities and Exchange Commission, Operations Center, 6432 General Green Way, Stop 0-3, Alexandria, VA 22312; and (D) submitted under cover letter that identifies Royal Alliance as a Respondent in these proceedings, and the file number of these proceedings, a copy of which cover letter and money order or check shall be sent to Arthur S. Gabinet, District Administrator, Securities and Exchange Commission, 701 Market Street, Suite 2000, Philadelphia, PA 19106.
Such civil money penalty may be distributed pursuant to Section 308(a) of the Sarbanes-Oxley Act of 2002 ("Fair Fund distribution"). Regardless of whether any such Fair Fund distribution is made, amounts ordered to be paid as civil money penalties pursuant to this Order shall be treated as penalties paid to the government for all purposes, including tax purposes. To preserve the deterrent effect of the civil penalty, Respondent Royal Alliance agrees that it shall not, in any Related Investor Action, benefit from any offset or reduction of any investor's claim by the amount of any Fair Fund distribution to such investor in this proceeding that is proportionally attributable to the civil penalty paid by Respondent Royal Alliance ("Penalty Offset"). If the court in any Related Investor Action grants such an offset or reduction, Respondent Royal Alliance agrees that it shall, within 30 days after the entry of a final order granting the offset or reduction, notify the Commission's counsel in this action and pay the amount of the Penalty Offset to the United States Treasury or to a Fair Fund, as the Commission directs. Such a payment shall not be deemed an additional civil penalty and shall not be deemed to change the amount of the civil penalty imposed against Respondent in this proceeding. For purposes of this paragraph, a "Related Investor Action" means a private damages action brought against Respondent Royal Alliance by or on behalf of one or more investors based on substantially the same facts as alleged in the Order in this proceeding; and
G. Royal Alliance shall comply with its undertakings to:
1) Maintain the revised policies, procedures and systems, as described above, that it implemented to enhance the supervision of Class B share sales; and
2) Review, with the assistance of outside counsel, its procedures and systems regarding the sale of Class B shares for compliance with the federal securities laws and regulations, and the rules of the NASD and the New York Stock Exchange. Within 90 days of the issuance of this Order, Royal Alliance undertakes and agrees to inform the staff in writing that it has completed its review and that, if necessary, it has established additional systems or procedures reasonably designed to achieve compliance with those laws, regulations, and rules concerning the sale of Class B shares.
By the Commission.
Jonathan G. Katz
Secretary